Using the tools of modern finance and risk management, it is possible to measure and model environmental risks. Environmental risks can be thought of as long run risks which naturally influence portfolio decisions, including insurance. In our Climate Risk Analysis, we examine the performance of portfolios designed to hedge against the risks associated with climate change.
A risk is the potential of losing something of value. It is an uncertain future outcome. In finance, we often compute mean loss of value of assets or portfolios using measures like Value at Risk, Expected Shortfall or other types of tail risk. Some risks are in the distant future and we may only have rough ideas of the probabilities of occurrence or loss. Nevertheless, we take these into account in our daily life and financial decisions. For example we buy life insurance and long term care insurance to reduce expected losses. We buy credit default swaps, treasury bonds and even gold to reduce long run risks. We fund our pensions.
Over the past decade, the economic effects of climate change have become a salient issue for many investors. More and better information about climate change risks has become available, and the first consequences of climate change are starting to directly affect parts of the population. As a result, investors are increasingly looking for ways to use financial markets to hedge exposure to climate change by putting together portfolios that will pay off in states of the world with particularly bad climate outcomes. In our Climate Risk Analysis, we examine portfolios that may hedge against climate change exposure. By applying the tools of financial analysis of long run risk to these portfolios, we can gain a better understanding of their performance.